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Taxes & Accounting

2001-12-01 14:33:00

What do we need to do before the end of the year?

Question: Is there a list somewhere available that reminds people of the things they can do prior to December 31st to minimize income tax liabilities?

Answer:  The simple answer is yes and no.   There are indeed hundreds, maybe thousands of lists available.  Using the internet, you can find them on virtually every accounting firm's web site, many tax attorney web sites and other business web sites professing to have the answer to avoiding income taxes.  You can find them in publications at the public library, bookstores, garage sales and within articles that will be printed in almost every newspaper and magazine that has a business or money section.   This provides for the simple answer "yes".Often the items on a list raise new questions that did not exist before the list was read.  Since the list cannot answer a question, you are left to interpret what the item means or how to apply it.  Nearly every list will advise you that any one item may not be appropriate for your circumstances.  With this dilemma, many of us either give up trying to understand the list or choose to follow the recommendation without really understanding it only to find later that it really did not help us and many times actually cost us more.  So to the question of the existence of a unique list to your specific circumstance, the simple answer must be "no". In a more general sense, let’s take a look at some of the things that should be done before December 31 to minimize  income taxes. Like a road map that guides you to a destination, you need to know the beginning point.  This article may be too late, but I have always advised our clients to use the Thanksgiving holiday as a planning weekend for their year-end tax strategies.  Commit to 2 or 3 hours to sketch out the details of your current year's taxable income.  If you prepare your own return you should have an understanding of "gross income", "adjusted gross income", "itemized deductions", "standard deduction", and "taxable income".   If someone else prepares your return, your knowledge may be limited to understanding "gross income" and "deductions".   Another key element of tax planning is to understand that saving taxes is a part of a whole.  What I think most of us are interested in is preserving wealth.  In other words, to spend money just to save taxes may result in spending a dollar to save 30 cents.  You may feel better at saving 30 cents in taxes, but you lost a dollar in doing it.   Realizing that, at the end of November, over 90% of the year is complete, you can easily estimate the rest of the year.  If you prepare your own return, you can compute your 2001 income tax liability with reasonable accuracy.  You may have to use last year's tax tables, but they will be fairly close.  If someone else prepares your return, you should call your advisor for a tax estimate and recommendations on minimizing taxes and preserving wealth.  In either event, you are now in a position to know whether you (1) will itemize your deductions, (2) will not itemize your deductions or (3) you might itemize your deductions.  This determination is critical to selecting the strategies you attempt.   Common tax planning strategies:1. For itemizers (those taxpayers whose itemized deductions exceed the standard deduction before implementing the strategy):a. Consider pre-paying your state income tax liability before December 31.  Exercise caution, as taxpayers subject to alternative minimum tax will not benefit from this strategy.b. Consider paying 100% (rather than just 50%) of your real estate tax prior to December 31.  Exercise caution, as taxpayers subject to alternative minimum tax will not benefit from this strategy.c. Remember to deduct your personal property tax on automobiles, boats, and trailers.   If you bought a new car during the year, you may have paid these amounts at two different dates.d. Clean out the closet.  This simple strategy requires a little bit of time but saves income taxes as you clean your house.  There are several charitable organizations that accept contributions of used articles of clothing and household goods.  Make and keep an accurate list of the items you donate and determine a fair value of the items given.  These values would be comparable to what a thrift store would receive for them.  Do not attempt to use this strategy to clean out items of no real value or inflate the value of the item.  e. Consider paying your January mortgage payment by December 26.  The payment should post before year-end and your mortgage interest deduction will include December interest.f. Consider paying your January charitable pledge in December.g. If you refinanced your mortgage that had been previously refinanced, remember to deduct your unamortized loan interest from the previous refinancing. h. Remember to deduct the interest element of special assessments on your personal residence.  The principal portion is not deductible. i. Remember to deduct the balance due on your 2000 state income tax return if you paid this amount in the current year.2. For those who will not itemize or those that may itemize (those taxpayers whose itemized deductions do not exceed the standard deduction):a.  The year 2001 standard deduction is $7,600 for married couples filing a joint return, $4,550 for single taxpayers.   That means you get a free (doesn't cost you anything) deduction.   In evaluating whether you should pay out funds to be able to itemize, you need to determine your real benefit.  For example, assume you are filing a joint return as married couple and you have determined that you currently have $7,000 in itemized deductions and you are considering a deductible expense of $1,000.  If you pay this item, you will exceed the standard deduction by $400.  (7,000+1000-7600).  If your tax rate is 27.5%, the tax reduction on your additional expense is $110 ($400 x 27.5%), or 11%.  You may want to do this, but there may be a way to achieve higher tax reduction.b. If your normal itemized deductions consistently amount to a total just under the standard deduction, you have the opportunity to use the free deductions one year and double up your itemized deductions the next year. This common strategy is referred to as bunching your deductions, but it does require you to plan and plan for more than one year. c. To follow our example, let us assume our itemized deductions of $7,000 is made up of $3,000 in mortgage interest,  $2,000 in state income taxes, $1,200 in real estate tax, $300 in personal property tax, and $500 in charitable contributions.   For this example our two-year total of these amounts would be $14,000 and our two-year total of standard deductions would be $15,200.  If we take the standard in 2001, then we will delay paying our charities, delay our real estate tax and not prepay our January 1st mortgage payment.  We will also limit our state income tax payments to an amount sufficient to avoid penalties.  d. In year 2002 we will plan to pay all of our real estate tax, our current and pledged contributions, 13 months of mortgage interest and as much state income tax as possible. Our year 2002 itemized deductions could easily look like $1,800 in real estate tax, $800 in charities, $3,300 in mortgage interest and $2,500 in state income tax.  These amounts total $8,400.  When added to our year 2001 standard deduction, our two-year total deduction equals $16,000.  Our two-year total expenditures equal $14,000.  We just saved $220 in ($16,000-$15,200 @ 27.5%) by simply planning what we had to spend anyway.   And, if we spend that extra $1,000 anticipated above, our tax reduction is 27.5% rather than 11%, an extra $165. e. The example shown is a simplified presentation and may not work for you.  What it should show you is that with a little planning, you can save taxes without looking for the newest "hot tip".3. For all taxpayers:a. Review your gains and losses on investments, both realized and unrealized.  It is possible that you have some investments that have gone down in value.  You are allowed to deduct up to $3,000 in capital losses in excess of your capital gains.  Be wary of wash sale rules and mutual fund distributions.b. Avoid buying mutual fund investments late in the year or before the ex dividend date.  You could wind up converting your after tax investment dollar to a taxable dividend amount. c. If you sold any dividend reinvestment securities, remember to include those dividend re-investments as part of your tax basis. d. If you are currently over 70 and half and are in pay status on tax deferred retirement accounts, be aware that there are new rules on required minimum distributions.  These rules reduce the amounts you must receive in most cases.  Review these rules and the strategies available to you in reducing your 2001 taxable income. e. For business owners there is the ability to expense equipment purchases up to $24,000 for equipment placed in service before year-end.  For 2001, there is an election available to relax mid quarter convention rules for other purchases. f. Review available cafeteria plan elections prior to year-end.  This item will effect next year's taxable income. Some or all of these items may be inappropriate for your particular circumstance and I have only scratched the surface of minimizing taxes and preserving wealth.  Relying on these strategies without proper knowledge or advice is not recommended.   We are currently in the first year of a scheduled ten-year tax law change.  This law anticipates a gradual reduction in tax rates and when that is the case, the general rule is to accelerate deductions and delay income.  These laws have a way of changing overnight and you must continually monitor these changes to ensure your strategies are sound.  I strongly advise you to review your tax and financial planning with a qualified individual.